7.3. INTEREST RATE SWAPS 275
by the method used to determine the interest payment (for instance, floating rate
versus fixed rate). Because both underlying loans are in the same currency, there is
no initial exchange of principals and no final amortization. In that sense, the two
loans arenotional(fictitious, or theoretical). The only cash flows that are swapped
are the interest streams on each of the notional loans. In short, parties A and
B simply agree to pay/receive the difference between two interest streams on the
notional loan amounts.
The standard interest swap is the fixed-for-floating swap or coupon swap. The
base swap is rarer. We discuss each of them in turn.
7.3.1 Coupon Swaps (Fixed-for-Floating)
We now describe the characteristics of a fixed-for-floating swap and how one can
value such a financial contract.
Characteristics of the Fixed-for-Floating Swap
In our discussion of the fixed-for-fixed currency swap, we saw that, in terms of the
risk spread above the risk-free rate, a firm often has a comparative advantage in
one currency but may prefer to borrow in another currency. The firm can retain
its favorable risk spread and still change the loan’s currency of denomination by
borrowing in the most favorable market and swapping the loan into the preferred
currency. The same holds for the fixed-for-floating swap except that, instead of
a preferred currency, the firm now has a preferred type of interest payment. For
instance, the firm may have a preference for financing at a fixed rate, but the risk
spread in the floating-rate market may be lower. To retain its advantage of a lower
spread in the floating-rate market, the firm can borrow at a floating rate, and swap
the loan into a fixed-rate loan using a fixed-for-floating swap.
Because the swap contract is almost risk free, the interest rates used in the swap
contract are (near) risk-free rates. For the floating-rate leg of the swap, the rate
is traditionallyliboror a similar money market rate, while the relevant interest
rate for the fixed-rate leg is the same N-year swap rate as used in fixed-for-fixed
currency swaps. In fact, traditionally, the fixed swap rate wasdefinedas the rate
which the swap dealer thought to be as good aslibor, that is, which she or he was
willing to take as the fixed-rate leg in a fixed-for-floating or floating-for-fixed swap.
Also,liborin currency X is also defined as acceptable againstliborin currency
Y, which in turn must be acceptable against currency-Y fixed.
Example 7.6
An AA Irish company wants to borrownzdto finance (and partially hedge) its direct
investment in New Zealand. Because the company is better known in London than in
Auckland, it decides to tap the euro-nzdmarket rather than the loan market in New
Zealand. Asnzdinterest rates are rather volatile, the company prefers fixed-rate